Discounted Cash Flow (DCF)
What's a company worth? Take all the free cash flow it will generate in the future, translate it back into today's money, and add it up.
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Text version · Fundamental Analysis, lesson 5: “Discounted Cash Flow (DCF)”
What's a company worth? Take all the free cash flow it will generate in the future, translate it back into today's money, and add it up.
Future money is worth less
$1 today is worth more than $1 next year. DCF divides each year's free cash flow by (1 + discount rate) raised to the number of years, bringing it back to today, then adds them up.
Terminal value is often the biggest piece
The value beyond the forecast period is the terminal value = next year's cash flow ÷ (discount rate − perpetual growth rate). It's often more than half the valuation, and if the two rates get close, the result shoots up.
Leave a margin of safety
intrinsic value (company) is only a range. Buy only when the price is clearly below your estimate, say 20%–30% lower. That gap is your margin of safety, a cushion in case your assumptions are wrong.
Key takeaways
- $1 today is worth more than $1 next year: future cash flows are divided by (1 + discount rate) raised to the number of years.
- Terminal value = next year's cash flow ÷ (discount rate − perpetual growth rate). It's often the bulk of the valuation and very sensitive to assumptions.
- The point of a DCF isn't a precise number; it's seeing clearly "what you have to believe for the price to make sense".
- Only buy when the price is clearly below your valuation, leaving a margin of safety in case your assumptions are wrong.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Look at the default result: what's the value per share? What percentage of the valuation is terminal value?
- Raise the discount rate from 9% to 11%: what does the value per share drop to? Roughly what fraction is lost?
- Back at 9%, find the cell in the sensitivity table closest to $100: what discount rate and perpetual growth rate does it correspond to?
- Raise the perpetual growth rate to 5%: what's the valuation now? Then lower the discount rate to 5%: what warning appears?
Quiz and explanations
- 1. With a 10% discount rate, what's $110 a year from now worth today?
- Answer: $100.$110 ÷ 1.1 = $100.
- 2. All else equal, raising the discount rate makes the DCF valuation…
- Answer: Fall.Future money gets a bigger discount, so its present value shrinks.
- 3. Next year's free cash flow is $10, the discount rate 9% and perpetual growth 4%. Using the perpetual growth formula, what's the value?
- Answer: $200.$10 ÷ (9% − 4%) = $10 ÷ 0.05 = $200.
Terms in this lesson
- DCF: Discounting each future year's free cash flow back to today and adding them up to estimate a company's intrinsic value.
- discount rate (Discount Rate): The annual rate used to convert future money into today's value, reflecting the cost of capital and risk; the higher it is, the lower the present value.
- intrinsic value (company) (Intrinsic Value): What a company “should” be worth based on the cash it can generate in the future, which may be above or below its share price.
- margin of safety (Margin of Safety): The gap between estimated intrinsic value and the price you pay; buying only well below your estimate leaves room for error.
- terminal value (Terminal Value): The total value of all cash flows beyond the forecast period, usually estimated with a perpetual growth formula and often the bulk of the valuation.